There's increasing worry about Americans' debt burdens, yet what about its corporate citizens? Companies, like individuals, have to be mindful of their balance sheets. In fact, with the economy cooling and interest rates still on the rise, it might be a good time for investors to reevaluate stocks of highly leveraged companies, which may be at risk in the event of a downturn.
A company's leverage can be measured in various ways, but the concept is essentially the ratio of debt to assets. "It's similar to you and I owning a home," says Stephen Biggar, director of North American equity research at Standard & Poor's. When a person buys a home, the mortgage is the debt and the down payment represents the assets. The homeowner becomes financially leveraged.
Not all leverage is created equal. The typical amount of leverage varies from industry to industry, with certain groups like industrial or financial stocks likelier than others to have high debt ratios. For the Standard & Poor's 500-stock index, the equal-weighted average percentage of long-term debt to invested capital is 33.2%. The market-cap weighted average is 34.2%.
A highly leveraged company runs the risk of defaulting on its debts. But, as with buying a home, going into debt may turn out to be a smart investment in the long run (see BusinessWeek.com, 9/12/05, "Bring on the Battered Debt"). But, of course, keeping debt at the right level is everything. This week's Five for the Money looks at five relatively highly leveraged companies and whether their debt levels should give investors pause.
Where did Clorox's (CLX) sparkle go? The Oakland (Calif.) cleaning products maker faces rising commodity prices and increased competition, analysts say. The company has also been beset with other misfortunes: Chief Executive Jerry Johnston resigned earlier this year after a heart attack, and Clorox has not yet named a replacement. A Clorox spokesperson did not return calls prior to deadline.
The name synonymous with bleach is the most highly leveraged company in the household-products group by long-term debt to capitalization, according to S&P. Clorox's long-term debt was 128.5% of its capitalization in 2005, up from 21.7% in 2004. On June 16, Fitch Ratings maintained the company's A- debt rating but lowered its outlook from stable to negative.
In late 2004, Clorox agreed to buy back German conglomerate Henkel's 29% stake in the company. The $2.8 billion deal is the source of much of Clorox's increased debt load, which it should be able to pay back, analysts say. "With earnings before interest and taxes at 10 times interest expense, we believe its financial leverage is manageable," notes Morningstar analyst Lauren DeSanto in a July 18 report. DeSanto gives the stock a three-star rating out of five.
Still, others suggest the company is in no hurry to get out of debt. Clorox "does not plan to return to its pre-Henkel underlevered capital structure," wrote Goldman Sachs analyst Amy Low Chasen in a May 10 note. The cleaning products maker instead plans to entice investors with a combination of share buybacks and increased dividends, according to Chasen, who has a neutral recommendation on the stock. (Goldman has an investment banking relationship with Clorox.)
Clorox stock closed at $59.52 on July 26, down 8.5% after hitting a 52-week high on Apr. 27. Clorox's prospects look good despite the increasing threat from private-label brands, but its stock price may not, analysts say. "We like the story, just not at current valuation," Deutsche Bank analyst Bill Schmitz observed in a June 13 report. Schmitz has a hold recommendation on the stock. (Deutsche seeks to do business with companies covered in its research reports.)
2. Cablevision Systems
When it comes to Cablevision Systems (CVC), debt-conscious investors may want to consider changing the channel. The Bethpage (N.Y.) media, entertainment, and telecom giant's long-term debt was 136.9% of capital in 2005, its highest level since 1999. While analyst opinion is mixed, some worry about the company's balance sheet, which is highly leveraged, even for the capital-intensive cable industry.
In a written statement, the Long Island cable operator's chief financial officer, Michael Huseby, attributes the company's leverage to a recent $3 billion special dividend and "the substantial investment we have already made in our core cable business." The company exceeded $5 billion in revenue over the past year and recently surpassed 1 million voice service customers, he notes.
Still, Cablevision has a habit of taking on debt for unrelated ventures, including consumer-electronics stores and a movie-theater chain, points out Morningstar analyst Kane Burns, who gives the stock a one-star rating. "We continue to have concerns about the firm's poor profitability, heavy debt load, and corporate governance," Burns said in a June 24 report.
Others still see upside. In early May, Cablevision moved its 2006 financial targets higher. The company's bundled digital-phone and high-speed Internet promotion also looks promising, according to Standard & Poor's analyst Tuna Amobi, who has a buy recommendation on the stock. Shares finished at $21.36 on July 26, up 18.7% from their 52-week low on Apr. 25.
Nevertheless, fierce competition from rival Verizon (VZ) might limit Cablevision's expansion, some analysts say. "It is probably unrealistic to expect Cablevision's positive basic subscriber growth to continue much beyond this year," Credit Suisse analyst Bryan Kraft wrote in a May 9 report. Kraft has a neutral recommendation on Cablevision. (Credit Suisse has an investment banking relationship with Cablevision and owns 1% or more of a class of its securities.)
3. Weight Watchers
Weight Watchers (WTW) may help dieters cut out the fat, but its balance sheet is relatively debt-heavy. The New York company led the personal services group in 2005 with long-term debt weighing in at 112.2% of capital, up from 70.3% a year earlier. Still, as the low-carb craze fades, Weight Watchers stock could keep getting in shape, some analysts say. A company spokesperson declined to comment due to a quiet period.
Despite the high leverage, Weight Watchers' financial health is "decent," according to Morningstar analyst Kristan Rowland, who rates the stock four stars. "We think the company should have no problem paying down its debt, as free cash flow is healthy” at 24.2% of revenue in 2005, Rowland notes. (Editor's Note: This story has been updated to include more recent free cash flow data for Weight Watchers.)
Weight Watchers' strong brand and doctor-recommended methods should help its business grow while the latest diet fad goes out of fashion, others say. Of all major weight-loss programs, Weight Watchers' classroom-based approach is the only one with empirical evidence of its success, points out Bank of America analyst Scott Mushkin, who has a buy recommendation on the stock. (Bank of America has an investment banking relationship with Weight Watchers and owns 1% or more of a class of its securities.)
Still, the shares have taken off weight and kept it off, ending at $40 on July 26, an increase of roughly 1% since hitting a 52-week low July 21.
4. Reader's Digest Assn.
The condensed version of this story could read something like this: Heavy debt load, economic slowdown, declining profits. Reader's Digest Assn. (RDA), which publishes dentists' office mainstay Reader's Digest, had long-term debt of 60.4% of its capitalization in 2005. That compares with 36.5% for Scholastic (SCHL), the next most highly leveraged stock in the large publisher group, according to S—P.
Richard Clark, senior vice-president of investor relations at Reader's Digest, points out that the company's leverage is much lower than that of fellow publisher Primedia (PRM), which belongs to a different S&P stock group. Reader's Digest has lowered its debt from around four times earnings before interest, taxation, depreciation, and amortization (EBITDA) in 2002 to about three times EBITDA in 2006, Clark says.
The Pleasantville (N.Y.) company agreed in 2002 to buy magazine publisher Reiman Publications for $760 million in cash. At the time, the deal was the largest in the industry in four years, and it required Reader's Digest to take on extra leverage. Analysts, though, are also relatively sanguine about the company's debt load.
Reader's Digest has successfully turned around its QSP youth fund-raising division and could have similar success as it expands operations internationally, according to S&P analyst James Peters, who has a buy recommendation on the stock. In a May 18 report, Peters also points to expected revenue growth from new products and new business ventures, such as recently launched party planning business Taste of Home Entertaining.
Shares finished at $13.81 on July 26, up 5.2% from a 52-week low touched on June 13. Still, some analysts spot few factors likely to improve the stock price further, particularly as Reader's Digest's full-year earnings tend to be weighed toward December-quarter results. "We do not see a catalyst for [the] shares near term, given its seasonality and general economic concerns," Merrill Lynch analyst Karl Choi wrote in a July 10 report. Choi has a neutral recommendation on the stock. (Merrill owns 1% or more of Reader's Digest stock and makes a market in the securities.)
5. Red Hat
Tech is typically among the less leveraged sectors. Open-source software maker Red Hat (RHAT), on the other hand, had long-term debt representing 54.4% of capital in 2005, compared to 0% for most other small systems-software companies. Debt is only one risk to consider when looking at the Raleigh (N.C.) company, but some analysts say its share price probably won't fall much further.
Red Hat raised $600 million with a bond issuance in January, 2004, which accounts for some of its debt. The bond was for general corporate purposes as well as acquisitions and expansion, and it's on track to be repaid, a company spokesperson says. "In order to give ourselves a head start, we issued that bond, and it's really allowed us to grow the company," the spokesperson says.
Shares closed at $23.77 on July 26, a 26.8% drop from a 52-week high touched on May 8. In late June, the stock lost 6.4% in a single day after the company reported an 11% increase in quarterly profit. Red Hat executives also warned that the company's JBoss acquisition might not boost the bottom line as soon as expected (see BusinessWeek.com, 4/11/06, "Red Hat's Red-Hot Deal").
Potential competition from Oracle (ORCL) or Microsoft's (MSFT) Vista represents another risk to Red Hat's stock price, according to S&P analyst Clyde Montevirgen, who has a hold rating on the shares.
On the bullish side, an Oracle version of Red Hat's flagship Linux software would be more difficult than it sounds, maintains Citigroup analyst Brent Thill, who has a buy recommendation on the stock. Red Hat stands to maintain its 80% Linux market share in the next several years while expanding operating margins, Thill wrote July 13. (Citigroup has an investment banking relationship with Red Hat and makes a market in its securities.)
Just because leverage is high doesn't mean a shareholder should drop the stock. But a high debt-to-capital ratio can be worth keeping in mind for investors leery of a downturn.